Contains a descriptive of the following capital structure theories: 1. Net Income Approach 2. Net Operating Income Approach 3. Miller Modigliani Hypothesis 4. Traditional Approach

1. Capital Structure
Theories
Ayush Jain

2. Contents
O Net Income Approach
O Net Operating Income Approach
O Miller Modigliani Approach
O Traditional Approach

3. Net Income Approach

4. Assumptions to NI Approach
O Cost of Equity and Cost of Debt are
constant
O Overall cost of capital (Ko) > Cost of
Equity (Ke) > Cost of Debt (Kd)
O No Taxes applicable on income
O The expectations of investors do not
change with the increased use of debt

5. Net Income Approach
O Everything else remaining constant, with
the influx of debt in the capital structure,
the overall cost of capital (Ko) of the firm
decreases and thus increasing the value
of the firm
O Value of Firm = Value of Debt + Value of Equity
O Value of Equity = Net Income/Ke
O In such a case, the value of an unlevered
firm would be lower than a levered firm,
this is called trading on equity

6. Relation of Costs in NI
approach
0
2
4
6
8
10
12
14
16
0 10 20 30 40 50 60 70 80 90 100
Ke
Kd
Ko

7. Net Operating
Income Approach

8. Assumptions of NOI Approach
O Use of Debt in Capital structure changes the
risk perception of the investors
O The Overall cost of capital (Ko) remains
constant for each mix of debt and equity
O Investors capitalize the operating income of
the firm to find its total value
O Value of equity = Value of firm – Value of Debt
O Even with increase in debt funding, the cost of
debt remains constant
O No Corporate Taxes

9. Net Operating Income
Approach
O Everything remaining constant, with the influx
of debt in the capital mix, the overall cost of
capital (Ko) remains constant, the cost of
equity (Ke) increases due to increase in
leverage causing increase in risk
O In such a case, while the Value of firm
remains constant, the value of equity of a
levered firm becomes higher than the value
of equity of an unlevered firm
O In such a case, Ke is given by Ke = Earnings
attributable to Equity holders/Equity Share
Capital

10. Relation of costs in NOI
Approach
0
10
20
30
40
50
60
70
0 10 20 30 40 50 60 70 80 90 100
Ke
Kd
Ko

11. Miller Modigliani
Approach

12. Introduction to Miller
Modigliani Approach
O MM Approach is an extension of the NOI
Approach, which suggests that there can
never be a situation of a firm being
unlevered.
O If a firm is unlevered, the investors of a
levered firm will undertake personal
leverage to obtain an arbitrage gain since
the equity of an unlevered firm would be
undervalued in the market

13. Assumptions of MM Approach
O No Corporate Taxes
O 100% Dividend payout ratio
O Perfect Capital Markets
O Investors free to buy and sell securities
O Investors can borrow at same rate as
corporations
O Investors are well informed and behave rationally
O No Transaction Costs
O Investors have same expectations for the NOI of
the company and use it as a basis to judge
companies.
O All companies work in homogeneous risk
environment

14. Arbitrage as per MM Approach
O Sell the equity of the levered firm
O Obtain debt funds in the same ratio as the
levered form for the value disinvested
O Invest it into the equity of an unlevered
firm
O Arbitrage gain
O Since the Ke is higher than Kd, the return
on the equity would be high enough to
cover the old return and the interest on
debt funds

15. MM Approach when
Corporate Taxes Exist
O In case corporate taxes exist, the value of
a levered firm will be lower than an
unlevered form, this is because interest is
tax deductible. It will exceed the unlevered
firm by the amount equal to the debt of the
levered firm multiplied by tax rate
O Value of Levered Firm (Vl) = Value of
unlevered firm (Vu) + Debt x Rate of Tax
O Vu = Profits attributable to ESH (PAT)/Ke
(Equity Capitalisation Rate)

16. Traditional Approach

17. Introduction to Traditional
Approach
O The NI and NOI approach are faulty as they are
unreasonable in their assumptions of the relations
between Ke, Kd, and Ko. It assumes one or the
other to be constant at any level of leverage.
O It is an intermediate approach between the two
extremes of NI and NOI approaches.
O This approach is more realistic as it does not
assume cost of equity, debt or overall cost to be
constant which cannot be due to change in risk
perceptions of both the investors and the lenders.
The risk increases with increased leverage and so
does the cost of debt

18. Optimum Capital Structure
O As per the traditional approach, the value of an
unlevered firm can be increased initially with the
influx of debt in the capital structure as a cheaper
source of finance.
O As the proportion of debt increases, the risk to
Equity investors increases, and thus the Ke also
increases.
O On such progression, the cheaper debt becomes
unavailable due to increasing leverage and thus
the debt also start to become costlier
O This brings the firm to such a point where the lower
cost debt introduced does not offset the cost of
equity released and the Ko increases

19. Optimum Capital Structure
(Contd.)
O In the beginning, with the introduction of
debt the Ko will decrease until a certain
level.
O After such a stage is attained, the
decreasing trend of the overall cost of
capital stops remains constant and then
start increasing.
O The optimum capital structure is at the
point where the overall cost start to
remain constant.

20. Relation of Costs under
Traditional Approach
0
5
10
15
20
25
30
0 10 20 30 40 50 60 70 80 90 100
Ke
Kd
Ko